Oil price hits all areas of economy

Any increase in oil prices is bad news for the economy and the latest surge is no exception.

Higher oil prices flow directly through to the rate of inflation when petrol pump prices go up. They also increase costs for other parts of the economy, particularly manufacturing, forcing up the price of goods in the shops.

Any hint that inflation is getting out of control will trigger the Bank of England to raise its interest rates, already on an upward trend. That would slow down the growth of the economy and increase mortgage and debt interest payments for borrowers.

On Thursday the 11 oil producing countries in Opec will meet in Beirut to discuss the rising price of oil and what, if anything, they should do about it.

Just like other commodities, oil prices follow basic market rules of supply and demand. When too much oil is pumped the petrol price falls and when production plunges prices surge.

But politics colours the economic picture more than any

other commodity. The Middle East holds nearly two thirds of the world's reserves and unrest in the region has consistently sparked rises in oil prices, from the Yom Kippur war in 1973 to the Iran/Iraq war in the Eighties.

In 1973, several of the Arab nations imposed an embargo on the western countries supporting Israel. Production fell by five million barrels a day and the price shot up.

However, at the current level of about $41 a barrel, economists and politicians hope that damage to the broader economy can be contained. If oil prices sink back below $40 within days there will be little long-term fallout.

But any longer term increase will quickly start to bite into economic growth. Today economists at the European Commission said growth could be slowed down by about 0.2 per cent if the $41 barrel sticks. That would be uncomfortable but fall far short of disaster.

Western economies are far less dependent on oil than they were in previous crises in the Seventies and Eighties. Manufacturing accounts for little more than 20 per cent of the UK economy now, compared with 30 per cent two decades ago.

The weakness of the dollar has also partially offset the oil price rise, which in real terms is still way below the peaks seen in 1974 and 1980. However, some economists fear that the world economy is getting perilously close to a "tipping point" that could be passed if a terrorist attack succeeds in knocking out a big chunk of Saudi oil production.

Former CIA officer Robert Baer said in his recent book Sleeping With The Devil: "Taking down Saudi Arabia's oil infrastructure is like spearing fish in a barrel." A co-ordinated assault could put the Saudis out of the oil business for two years and according to Baer, that "would be enough to bring the world's oil-addicted economies to their knees".

Such an attack would send oil prices spiralling to $60 a barrel or more. There would be an unavoidable spike in the rate of inflation in Britain, forcing interest rates up to seven or eight per cent.

That could trigger the long-awaited collapse in the housing market and increase debt payments for millions of borrowers already struggling after a decade-long spending boom. The recession that Gordon Brown has fought for so long to avoid would then only be a matter of time.